Monday, July 1, 2013

Why most dividend investors never succeed

Many investors believe that once they find the perfect dividend stock, they can just buy it, and kick back and collect the dividends for eternity. Unfortunately, even if you identified the perfect dividend growth stock, you can still lose money. This is because identifying and selecting an amazing stock, with amazing prospects, and attractive valuation is just part of the formula for investment success. The next part is the psychological traps that could cause you to do silly things.

The first reason why investors lose money is because they focus on stock quotations as a source of the value of a stock, rather than looking at fundamentals, and then determining whether the stock has much value. This could cause them to do silly things, such as selling during a bear market in order to avoid more losses. For example, if the stock price falls significantly, but fundamentals are fine, individual investors might sell in panic and lose money. For example, Coca-Cola Company (KO) was trading at $30.68 at the end of 2007, paid $0.76/share in annual dividends and earned $1.29 that year. By the end of 2008 however, this otherwise great business could have been acquired at $22.63. The fundamentals were still great, but if our investor panicked and sold out, they would have lost out. This investor would have not only missed out on dividend increases for the next five years, but also missed out on the potential for earnings and dividend raises for the next several decades after that.

The second reason why investors lose money is because they get emotionally attached to stocks they have owned, and do not have a clear exit plan, which would protect them. I have noticed that many investors tend to sell after a quick gain, but if things go south, they start rationalizing their actions and might hold on for too long. An example of holding on too long is if fundamentals deteriorate and companies cut or eliminate distributions. An example of that include shareholders who held on to Eastman Kodak (EK), Citigroup (C) and Washington Mutual (WM) after the companies cut or eliminated dividends, hoping for a revival, which of course never happened. In the case of Coca-Cola, if they had cut dividends in 2008, I would have sold out without even thinking about it. If the company survived however, I would have considered buying it again, provided it met my entry criteria.

Investors who purchase dividend stocks that subsequently cut dividends might want to reevaluate and sell. Statistically speaking, dividend cutters and eliminators have severely underperformed over the past 40 yrs. Investors would rationalize holding on to dividend cutters and remain hopeful, when they should have cut their losses and purchased the next dividend idea. For example, Frontier Communications (FTR) paid 25 cents/share every quarter in 2004. By 2010, the dividend was cut to 18.75 cents/share, followed by another cut to 10 cents/share in 2012.

Investors in Frontier (FTR) who are still holding on, hoping for a miracle, despite the fact that they have been burned twice might not be following the most optimal strategy for their dollars.

In hindsight, buying General Electric (GE) or Wells Fargo (WFC) right after their dividend cuts in 2009 would have generated outstanding profits. However, following the strategy of investing in dividend cutters would have previously led investors to buy stock in the likes of Lehman Brothers (LEH), Eastman Kodak (EK), Washington Mutual, Citigroup (C ) and Bank of America (BAC) after dividends were cut. This would have led to almost total wipeout of principal and the ability to generate dividend income from that portion of capital would have been substantially impaired.

The third reason why investors never succeed is because sitting on a stock that is working well, and doing absolutely nothing is very difficult. Few investors are psychologically ready to buy a stock, and see the company truly succeed over the next 10-20-30 years. If they sat on gains of several hundred percent, or even a thousand percent, they would ring the cash register. They could rationalize it by sayings such as "you never go broke taking a profit". This is nonsense. An individual investor will have about 20 truly exceptional investment ideas over their lifetimes.

This could be from the anywhere between 50-100+ investments they would make over their lifetimes. The remaining 30 – 80 investment would be flat, lose money or make a small amount of money. Chances are that some of these would go to zero as well. Consistently cutting the successful investments short could be the deciding factor that could make an otherwise well picked portfolio of stocks lose money over time.

To simplify this point, imagine that at the last day of 1984 you had $100,000 to invest. You purchased ten stocks – Enron, Worldcom, Eastman Kodak, General Motors, Wal-Mart Stores, Pan American World Airlines, Trans World Airlines, Bethlehem Steel, Kmart, and Circuit City. You simply allocated $10,000 to each investment and let dividends be reinvested automatically. Fast forward to 2013 and only one of the companies you purchased is still here – Wal-Mart Stores (WMT). You would have also received shares in Eastman Chemicals (EMN), through a spin-off from Eastman Kodak. The $10,000 investment in Kodak would have translated into 139 shares at the end of 1984. With dividend reinvestment, this number of shares would have translated into 544 Kodak shares worth $33,600 by the end of 1993. At the end of 1993 our investor would have been entitled to 136 shares of Eastman Chemicals.

The rest have gone bankrupt, and their stocks are worthless. The portfolio value is approximately $921,000 by May 2013, which translates into annual total returns of almost 8%/year. If our investor had followed re-balancing, or sold out Wal-Mart too early, they would have been wiped out. In reality, the chances of someone having such a disastrous stock picking skill is remote of course, but it still illustrates the idea that one should let the successful investments run for as long as possible.

The investor with the disastrous stock picking skills would have done much better had they sold after a dividend cut. Only one of the companies listed above had never paid dividends (Worldcom), and four of them paid fluctuating distributions ( General Motors, Bethlehem Steel, Pan Am and TWA).

The fourth reason why dividend investors never succeed is because they concentrate their portfolios in as little as 10-15 individual stocks. thus, many investors risk overexposure to only a few sectors. Overexposure to financials in 2007-2009 would have been a drag on dividend income. Overexposure to high yielding sectors such as REITs or MLPs or Utilities could also be disastrous for dividend incomes and total returns over time. Many investors who follow a concentrated approach tend to get fixated on either “beating the market” or chasing yield, which come with enormous risk to principle. Instead, a more balanced diversified portfolio consisting of at least 30 individual securities representative of as many sectors that make sense could provide for a more dependable dividend income stream, which has a higher margin of safety.

The fifth reason why most investors lose money is because they overtrade. They buy a stock, then sell it and try to find a better investment. This strategy always generates profits for stockbrokers and tax authorities, but not so much for individual investors. If one were particularly unlucky to not know what they are doing, and received results directly proportional to their expertise, then with a rapid amount of trading they can easily compound their losses.

Last but not least, some investors fail to follow their own research, or they might get bored by the amount of work involved and look for shortcuts. Some of these investors tend to read an article/analysis and then blindly follow its advice. If they lose money in the process, they seldom learn from the experience. Blindly following someone’s advice is a dangerous plan, because you do not know why the other person purchased the investment in the first place. As a result, one would never know whether they should hold on if things go sour or double up. This investor would also be unaware of the conditions at which point one should sell. They could panic if the security drops in value, especially since they are not aware why it was purchased in the first place. Chances are the other person might not let you know when they sold, or why they sold. Even if they did, one should never blindly follow others advise without doing their homework first.

Back in late 2012, when I analyzed Abbott Laboratories (ABT), I had mentioned that I was optimistic about it, and the two companies that it would split into on January 2, 2013. An investor informed me that what I was doing was stupid, because Dave Van Knapp had sold his holdings in the stock a few months earlier.

Needless to say, I found this "advise" to be very dangerous. Other times, investors have been blindly buying and selling stocks, simply because Warren Buffett might have been buying or selling. However, he also does make mistakes. For example, back in 1998 he sold Berkshire's position in McDonald's (MCD). Over the next 15 years, the stock increased in value by 2.50 - 3 times. In addition, back in 1967, Buffett sold his partnership position in Walt Disney (DIS) for a 50% profit. The $4 million position in the stock was acquired in 1966 . Had the partnership not sold Disney stock and reinvested dividends, it would have been worth $2.50 billion.

In conclusion, in this article I have outlined a few behaviors that I have found to be leading to losses for dividend investors. Some of these behavior have also been inspired by my own dealings in stocks. The most important take-away is not to beat yourself up about past mistakes however, but to learn from them, and continuously adapt and seek to obtain more wisdom.

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